The link between transparency and independence of central banks

Mega Publishing Limited
Journal of Risk & Control, 2014, 1(1), 51-60 | Dec 30, 2014

The link between transparency and independence of
central banks
Eleftherios Spyromitros1

Abstract
This paper, using a standard model of monetary delegation, highlights the relationship
between transparency and conservativeness of central banks. Precisely, we show that a
lack of transparency about the output objective of central banks positively affects the
optimal degree of conservativeness of the central bank. Empirical analysis confirms the
theoretical link highlighted in this study.
JEL classification numbers: E52, E58
Keywords: central bank independence, conservatism, transparency.

1 Introduction
Kydland & Prescott (1977) and Barro & Gordon (1983) enriched the economics
profession with an insight that changed the thinking about monetary policy. By assuming
that individuals form rational expectations and by including the behavior of government
in their model, they showed that even if the government and its citizens share the same
objectives, a discretionary policy causes a high average inflation (i.e., creates an inflation
bias). Policy rules are clearly superior to discretionary policy but unambiguously lack in
flexibility. Although removing the inflationary bias, commitment to non-state-contingent
rules leads to sub-optimal stabilization. Consequently, there is a trade-off between
credibility and flexibility. A large strand of the literature has considered solutions that
provide an appropriate balance between credibility and flexibility. The proposed solutions
can be grouped into reputational solutions and institutional solutions2.
In this paper, we focus on institutional solutions such as central bank independence and
transparency. Central banks which are politically, economically and personally
independent can solve the time-inconsistency problem of monetary policy because

inflation expectations are better anchored because surprise inflation generated by
1

Department of Economics, Democritus University of Thrace, Greece
e-mail:
2
For reputational solutions, see Barro and Gordon (1983) among others.
Article Info: Received: October 29, 2014. Revised: December 10, 2014
Published online : December 30, 2014


52

Eleftherios Spyromitros

politicians is prevented. By having witnessed a trend towards independent monetary
policymaking with increasingly transparent actions, we should draw some conclusions
about the desirability of central bank transparency in this specific context3. Theoretical
models have mainly considered central bank independence by the weight placed on the
objective of inflation. Precisely, when a central bank is more concerned about inflation
than an elected government, then the central bank is characterized as a conservative
central bank à la Rogoff (Rogoff, 1985). According to this view, there is a positive link
between the degree of central bank independence and the degree of conservatism which
increases credibility in pursuing low inflation. However, the issue of central bank
independence can also be expressed by a central bank that follows its own objectives, but
also takes into account the objectives of the government. Therefore, considering both
central bank’s and government’s objectives when deciding on policy, central bank
independence can be seen as the relative weight on the central bank’s own objectives. In
this context, the link between central bank independence and conservatism has been
investigated both theoretically and empirically by Eijffinger & Hoeberichts (1998; 2008),

and they found a negative relationship between these two concepts4. In our study, we
abstract, however, from this interpretation, since we do not relate independence in terms
of a specific parameter. In other words, we consider that central bank independence and
conservatism are positively linked.
The existing literature characterizes central bank independence as the institutional device
associated with lower inflation and no less growth5. However, delegating monetary policy
to unelected officials creates a democratic deficit (Stiglitz, 1998) which underlines the
need to have more accountable central banks6. Advocates of more accountability consider
transparency as an important practical prerequisite for accountability (Briault et al., 1997;
Buiter, 1999). In addition to the accountability arguments for a positive relationship
between transparency and independence, there are also political economy arguments that
support this view. Eijffinger, et al. (2000), using a simple Lucas type model with an
overriding mechanism, show that central bank transparency about the preferences for
inflation stabilization increases effective central bank independence7, leading to a lower
expected inflation rate and less stabilization of cost-push shocks. Geraats (2002b) presents
further economic arguments in favor of a positive correlation between transparency and
independence, motivated by the empirical findings of Fry et al. (2000). By focusing on
the disclosure of information incorporated in policy decisions, Geraats (2002b) finds that
higher central bank transparency is more likely to occur when central banks are
3

For a survey on earlier studies highlighting the desirability of central bank transparency, see
Eijffinger & van der Cruijsen (2010). More recent studies highlight the important role of central
bank transparency on the transmission mechanism of monetary policy (Papadamou, 2013;
Papadamou et al., 2014a) and financial stability (Papadamou et al., 2014b).
4
A lack of central bank independence can be compensated by choosing more conservative central
bankers.
5
Theoretical and empirical studies for central bank independence can be found in Eijffinger & De

Haan (1996), Cukierman (1998) and Kissmer & Wagner (1998).
6
Although some aspects of accountability enhances independence, it seems that there is a negative
relationship between independence and accountability of central banks as highlighted in Briault et
al. (1997) and De Haan et al.(2013).
7
See Geraats (2002a) for a distinction between political, economic, procedural, policy and
operational transparency.


The link between transparency and independence of central banks

53

completely independent. However, if monetary policy is delegated to a conservative
central bank that is subject to political pressures, central bank's effective independence is
negatively affected and therefore greater economic transparency is not beneficial.
Walsh (2003) highlights the trade-off between accountability and stabilization which
depends on the degree of transparency about the output target. It is shown that uncertainty
about central bank preferences increases the optimal penalty to place on achieving an
inflation target.
Another more recent study (Hughes Hallett & Liebich, 2006) shows that there is an
important interaction between the optimal degree of transparency and the institutional
setting. Using a standard Kydland & Prescott (1977) and Barro & Gordon (1983) noncooperative game framework and allowing for monitoring and punishments costs, the
relationship between goal independence and goal transparency is examined8.They show
that goal independence will be negatively related to accountability and goal transparency.
It is also shown that goal-independence and goal transparency desirability varies across
players. In particular, policymakers are in favor of goal independence, while the private
sector will prefer goal transparency.
This paper can be related to the literature highlighting the relationship between

transparency and independence. Precisely, our study is closely linked to the study of
Walsh (2003), however we use a different framework and our objective is to find the way
that central bank conservativeness à la Rogoff may be affected by the lack of
transparency about the output target without focusing on incentive systems, monitoring,
and accountability issues. We also provide empirical evidence of the relationship
investigated.
Our paper is organized as follows. Section 2 investigates the relationship between central
bank transparency and independence using a standard model of monetary delegation and
presents the theoretical results. Section 3 presents the empirical results and section 4
concludes.

2 The Model
Following the time-inconsistency literature, we assume that policy makers and/or
governments (society) have over-ambitious output targets to compensate for market
imperfections, tax distortions, or for political economy reasons. The central banker is also
assumed to be optimally conservative à la Rogoff (1985) and cares both about inflation
stabilization and output stabilization. Furthermore, we suppose that central bank
transparency issues arise from asymmetric information about the output target (i.e., an
unknown output objective).
The production function without supply shocks can be written as9:
𝑦𝑡 = 𝜋𝑡 − 𝜋𝑡𝑒 ,
8

(1)

In this study transparency emerges from the fact that the central bank has an explicit inflation
target.
9
An important reason for not including supply shocks in the production function is to separate the
uncertainty related to game behavior from the uncertainty in the economy's responses.

54

Eleftherios Spyromitros

where 𝑦𝑡 is the log of output, 𝜋𝑡 the actual rate of inflation, and 𝜋𝑡𝑒 the expected current
inflation.
We consider that both government and society do not like inflation and output to deviate
from their desired levels (we normalize the desired level of inflation at zero). The loss
function for the government (society) is given by:
𝐿𝑡 = [(𝑦𝑡 − 𝑦 ∗ )2 + 𝜋𝑡2 ],

(2)

where the output objective 𝑦 ∗ reflects the government's will to offset the distortions
affecting the labour market. The loss function of the conservative central bank is
described by the following equation:
𝑐𝑏 2
2
𝐿𝑐𝑏
𝑡 = [(𝑦𝑡 − 𝑦 ) + 𝐼𝜋𝑡 ],𝐼 > 1

(3)

where 𝑦 𝑐𝑏 is the stochastic output objective of the central bank and 𝐼 the degree of
inflation aversion or the degree of conservatism of the central bank which is superior to
that of the society. The public anticipates that central bank will choose 𝑦 ∗ as its objective.
In this respect, 𝑦 ∗ = 𝑦 𝑐𝑏 + 𝜃 , where 𝜃 is an error with 𝐸(𝜃) = 0 and 𝑉(𝜃) = 𝜎𝜃2 .
Consequently, 𝐸 𝑦 𝑐𝑏 = 𝐸 𝑦 ∗ = 𝑦 ∗ . Then, using the taxonomy of Geraats (2002a), full

political transparency occurs when both conditions 𝐸(𝜃) = 0 and 𝜎𝜃2 = 0 hold. In this
case, the lack of transparency is explained by the variability of 𝜃 , 𝜎𝜃2 . An increase
(decrease) in the variability of 𝜃 is associated with a decrease (increase) in the
transparency of the central bank respectively.
Substituting (1) into (3) and assuming that the central bank knows what the public's
perceptions are, it will minimize the following loss function:
𝑒
𝑐𝑏 2
2
min𝐿𝑐𝑏
𝑡 = 𝐸[(𝜋𝑡 − 𝜋𝑡 − 𝑦 ) + 𝐼𝜋𝑡 ], 𝐼 > 1.
𝜋

(4)

Minimizing (4) with respect to 𝜋𝑡 , it yields:
1

𝜋𝑡 = (1+𝐼) 𝜋𝑡𝑒 + 𝑦 𝑐𝑏

(5)

and solving for the expected current inflation 𝜋𝑡𝑒 , we get
1

𝜋𝑡𝑒 = 𝐼 𝑦 ∗ .

(6)

Thus, the equilibrium solutions for inflation and output are:

𝑦∗

𝑦 𝑐𝑏

𝜋𝑡 = 𝐼(1+𝐼) + (1+𝐼) ,

(7)


55

The link between transparency and independence of central banks
−𝜽

𝒚𝒕 = (𝟏+𝑰) .

(8)

Substituting (7) and (8) into (2), the expected government's loss can be expressed as a
function of the degree of conservatism 𝐼 and of the variability of𝜃, 𝜎𝜃2 . It follows:
∗𝟐

𝑬[𝑳𝒕 ] = 𝒚

+

𝝈𝟐𝜽 +𝒚∗
𝟏+𝑰

𝟐

𝟐

𝟐

+ 𝑰𝟐

𝒚∗
𝟏+𝑰 𝟐

𝟐

+𝑰

𝟐𝒚∗
𝟏+𝑰 𝟐

.

(9)

From the above equation, it is straightforward that the expected loss of the government is
decreasing with the degree of central bank’s conservatism. This latter negatively affects
the inflation bias arising from an output that exceeds the socially optimal value. We can
observe that 𝜎𝜃2 increases the losses since this uncertainty has a positive impact on
inflation bias. From (9), we establish the following proposition.
Proposition
Under the hypothesis that 𝜎𝜃2 > 0, central bank opacity positively affects the optimal
degree of central bank conservativeness. In other terms: 𝜕𝐼/𝜕𝜎𝜃2 > 0.
Proof:

Differentiating now (9) with respect to 𝐼 , to determine the optimal degree of
conservativeness. This first order condition can be written as:

𝐹 𝐼; 𝜎𝜃2 = −2

2
2
2
2
3𝑦 ∗ 𝐼+𝑦 ∗ 𝐼 3 +2𝜎𝜃2 𝐼 3 +3𝑦 ∗ 𝐼 2 +𝑦 ∗

(1+𝐼)3 𝐼 3

= 0.

It can be demonstrated that
∂𝐹(𝐼; 𝜎𝜃2 )
1
=
−4
<0
(1 + 𝐼)3
∂𝜎𝜃2
and
∂𝐹(𝐼;𝜎𝜃2 )
∂𝐼

2

=6

2

2

2

4𝑦 ∗ 𝐼+6𝑦 ∗ 𝐼 2 +4𝑦 ∗ 𝐼 3 +𝑦 ∗ 𝐼 4 +2𝜎𝜃2 𝐼 4 +𝑦 ∗
(1+𝐼)4 𝐼 4

2

>0.

Making use of the implicit function theorem, it yields that
∂𝐼
∂𝐹(𝐼; 𝜎𝜃2 )/ ∂𝜎𝜃2
=
−
> 0.
∂𝜎𝜃2
∂𝐹(𝐼; 𝜎𝜃2 )/ ∂𝐼


56

Eleftherios Spyromitros

The intuition behind this result is that greater opacity of the central bank (a higher 𝜎𝜃2 )
increases the losses of the government, inducing a higher inflation bias. In this context,

the optimal response of the central bank will be to increase the degree of conservativeness
of the central bank. In fact, a highly inflation averse central bank will reduce the losses of
the government, diminishing thus the inflation bias.

3 Empirical Investigation
The objective of this section is to investigate empirically the relation between
transparency and independence of central banks over the period 1998-2005 using a
sample of 29 countries 10 . In order to relate macroeconomic performance and policy
efficiency to central bank features, we require quantitative measures of these institutional
characteristics of the central bank. We first describe these characteristics and then we
focus on the linkage between these two measures.
In the literature several methods to construct central bank independence index are
proposed (Bade and Parkin, 1982; Cukierman et al., 1992,Fry et al. 2000, Polillo &
Guillén, 2005; Arnone et al. 2006) 11 . The most widely employed index is due to
Cukierman et al. (1992). This index reflects the legal independence of central banks
ranging from zero to one. Recently, Dincer & Eichengreen (2014) create an index of
independence for a large number of countries and an extended period of time. In our
study, we consider this latter index of central bank independence.
There are various types of methods to measure central bank transparency. The first one is
proposed by Fry et al.(2000). They measure central bank transparency using a survey on
the information revealed by central banks that improves the public understanding about
central bank’s actions. Alternatively, several authors construct an index of central bank
transparency, independently from central bankers opinions, based on actual information
disclosed by central banks (Bini-Smaghi & Gros, 2001; Siklos, 2002; De Haan et al.
2004; Eijffinger & Geraats, 2006). Most of the above studies constructed an index of
transparency for few central banks or a single point in time. Notable exception is the
index of Eijffinger & Geraats (2006) which is time varying. In this paper, we are
particularly interested in the index constructed by Dincer & Eichengreen (2007) which
extends Eijffinger and Geraats' index for a larger number of central banks.

10

Argentina, Australia, Canada, Chile, Croatia, Denmark, Estonia, Hungary, Iceland, Indonesia,
India, Israel, Jamaica, Jordan, Japan, Korea, Malaysia, Mexico, Norway, New Zealand, Philipines,
Romania, Russia, South Africa, Sweden, Thailand, Turkey, United Kingdom and United States of
America.
11

See Eijffinger and De Haan (1996), De Haan (1997), de Haan et al. (2003) for a literature review
on measures of independence.


The link between transparency and independence of central banks

57

This study, by using panel data analysis 12 , empirically investigates the theoretical
relationship examined in this paper concerning the role of transparency in the delegation
of monetary policy to a conservative and independent central bank.
To do so, we use the following general form:


y j ,t  a0  a1Tr j ,t    k x kj ,t  μ j  e j ,t

(10)

k 1

where central bank independence is the dependent variable y j ,t . The transparency index

Trj ,t is the regress or proposed based on the analytical model of section two. A set of
control variables X j ,t as important determinants of central bank independence are also
considered. Financial strength is captured through the ratio of the total value of shares
traded over the average market capitalization on an annual basis (Tro). In effect, an
increase in financial strength could be negatively related with central bank independence
because independence is consistent with less output stabilization and therefore more
volatile stock markets. Moreover, inflation variability is also taken into account as an
important determinant affecting the choice of central bank independence (s2inf). An
increase in inflation variability should make more pertinent the appointment of a
conservative and independent central bank. The e j ,t are the error terms for j=1,2, …,M
cross-sectional units, observed for t=1,2,…,T dated periods. The parameter a0 represents
the overall constant in the model, while the μ j represents cross section specific effects
(random or fixed).
We first discuss the specification of the model used in our analysis as follows: The F-tests
indicate that the FE model outperforms the pooled OLS. The Hausman test generally
suggests that the FE model is superior to the RE model. The specification tests suggested
by Frees (1995) and by Pesaran (2004) prove the existence of contemporaneous
correlations of errors, and the Wald test provides evidence for group-wise
heteroskedasticity. Therefore, in order to correct for any correlation within panels, our
regression is estimated with PCSEs.

12

The unit root tests suggest that all series are stationary.


58

Eleftherios Spyromitros
Table 1: Panel data estimation results for Independence vs. Transparency

Independent Variables

Expected Sign

Constant

+

Transparency Index

-

Tro

-

s2inf

+

R2
N =(ixT)

PCSE
0,500
(0.00)***
-0,006
(0.01)***
-0,080
(0.00)***

1,024
(0.09)*
8,7%
232

Specification tests

F-test (pooled OLS vs. FEM)
Hausman test (FEM vs REM)
Test of cross-sectional
independence by Frees
Test of cross-sectional
independence by Pesaran
Modified Wald test for
group wise
heteroskedasticity

82.36***
16,40***
6.079***
10.472***
2.70E+07***

Note: *,** and *** indicate statistical significance at the 10%, 5%, and 1% level
respectively.
The empirical result confirms the theoretical linkage described above. It is shown that
central bank independence is negatively correlated to central bank transparency.
Moreover, all expected signs are confirmed for all the control variables.

4 Conclusion

In this study, using a stylized monetary framework, we examine both theoretically and
empirically the effects of transparency about central bank’s output objectives on central
bank independence as defined by Rogoff (1985). As it is pointed out from our analysis,
the impact of transparency on conservativeness and therefore independence is negative.
Acknowledgements. I would like to thank the editor Stephanos Papadamou and an
anonymous referee for their constructive comments. I would also like to thank Moïse
Sidiropoulos and Panagiotis Tsintzos for their helpful comments on a previous version of
this paper.

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